Startups worried over funding prospects and falling valuations could soon have a bigger problem on their hands. The income tax department is discussing a controversial move to levy tax on those startups whose valuations have fallen recently on the grounds that the first premium was more than the firm's fair value.

Tax officials believe that Section 56 of the Income Tax Act confers on them the power to levy excess consideration, more than the fair value, against issue of shares. "Any consideration received by a company (start up) from a resident, against issue of shares, exceeds the fair market value of such shares, such excess consideration is taxable in the hands of the startup, as an income," Section 56 (2) (vii) (b) of the Income Tax Act says. Startups with marked down valuations may face tax notice Valuations of many startups have fallen sharply in recent times on worries over profitability, growth and intense competition. Tax officials believe that startups should be valued on the basis of the last round of investment. If this round's valuation is lower than the first round, excess premium, more than the fair value, is deemed to have been paid, some tax officials believe.

The tax department's move is unlikely to affect a vast number of startups who have been funded by venture capital funds registered with the Securities and Exchange Board of India. It is likely to affect only those investments made by funds not registered with Sebi and by angel investors. The startup community has already started taking steps to protect itself against the proposed move, having got wind of it from tax officials who have sent requests seeking detailed valuation reports for each round of investment. No formal notices have been issued yet.

"There has been a long standing demand by industry that the government should either do away with the angel tax or provide a monetary threshold for exemption for startups," said Amit Maheshwari, Partner, Ashok Maheshwary & Associates LLP. "With down rounds becoming a reality now, there is a concern that some of the resident angel investors could see their prior investments which were done at higher valuations in startups, getting taxed under Section 56 of the Income-tax Act, 196 in the hands of the company as the tax officers may take the current valuation as the base for valuing the prior investment," he added.

In many startups, the first round of investment would have been made by an angel investor at valuation of 2X, the second round by a VC at 2X. But a private equity investor could have come in at 1X. The revenue department would calculate the fair value of the startup based on the PE's investment. And tax could be slapped on the investment made by the angel investor.

Some of the tax officials say that many people in the past had misused the route of paying premium for converting unaccounted cash (black money) to legal money (white). "We have seen cases where people would start a company and through their friends get their black money invested in the company at a premium. I do not see random adjustments against startups, but due to lack of transparency in valuations, we have asked past and present valuation reports from some startups," an income tax officer told ET. While he did not clarify whether he himself would be making a tax adjustment, he said that it could happen in the "current fiscal." The government in the past had insulated VCs and fund of funds from the Income Tax act (Section 56 2viib). While a demand was also made to shield angel investors from this, the has said that even incubators should be insulated but the definition of what consists of an incubator is still missing. Fearing that they could be slapped with the tax notices many startups have already approached their consultants and lawyers. "The industry was hoping that angel investors would also be exempted from the said tax. However, the lack of implementation of any such exemptions is acting as a major impediment for startups," Archana Khosla Founder Partner Vertices Partners, a law firm specialising in working with the startups. The genesis of the problem lies in the fact that many startups have seen their valuations going southwards. In the last year or so even the unicorn startups have seen their valuations dipping.

Till recently, the valuation exercise of the funding received by startups was happening at their value based on projected sales, future free cash flows, exponential future growth and various other metrics all taken into consideration. "Now, since the subsequent rounds of funding are happening at a lower valuation for many startups, tax authorities can dispute the earlier valuation, pulling it down by questioning the basis, correlating it with the current valuation and demand tax on the price perceived to be overpaid in the first round. This is definitely going to make life tougher for startups that are already facing a very tough funding environment," said Maheshwari.